Austerity Cuts, The Annual Deficit And The National Debt

It’s pretty clear that many of the major economies of the world are in a mess and that austerity and cuts are going to be on the agenda for years.

This presents a challenging economic environment for businesses to operate in day-to-day and to plan for the future strategically.

I get very frustrated with the biased coverage of the austerity cuts in the news media and particularly on the BBC which seems determined to ruin its brand and reputation for impartiality as it plays politics. Personally I think it’s a disgrace for a publicly funded body to behave in this way.

One of the big ways coverage of the austerity measures gets distorted is through confusion over the annual deficit (often referred to as the deficit) and the national debt (often referred to as the debt).

I don’t know whether these two related concepts are confused through ignorance (which is shocking) or political gain (which is even worse).

The annual deficit is the shortfall between government spending (including interest on the debt) and revenue from taxation (and potentially other sources if major assets are sold in privatisation deals).

If government revenue exceeds expenditure in a year, then it is called an annual surplus.

The national debt is the accumulation of all the annual deficits and surpluses since records began.

This distinction is as fundamental as your personal income and wealth.

The annual deficit is a flow – a movement within a period.

The national debt is a balance – the total owed at a snapshot in time.

The annual deficit could stay the same each year for ten years – say £5 billion to keep the numbers simple – and it means the national debt increases from £5 billion in year 1 to £10 billion in year 2, £15 billion in year 3… all the way to £50 billion in year 10.

Just like your own personal spending, if you keep increasing the money you owe on a credit card, you reach the point where you can’t pay it back without major sacrifices (like losing your house) and if credit is too readily available, you reach the point where you can’t pay it back, whatever you do. At that stage you’re bankrupt.

Hopefully you never get yourself in that situation. I’ve spoken to people who have been there and it’s awful. I also know business owners who have lost a lot of money because their customers have gone bankrupt which in some cases is even worse because they are one step removed from the reckless spending.

What makes the debt proven even worse is the compound interest. The more you borrow, the more interest you have to pay. The more you owe, the higher the risk you are considered and the higher the interest rate you are charged. And since you don’t have the money to pay the interest, it gets added to the debt so you find yourself paying interest on the interest.

It’s the same for governments. They borrow by issuing government bonds (often called gilts) where they are given a fixed amount of money for a certain interest rate e.g. £100 million at 5% per annum interest.

These gilts are then traded on the market so if things don’t look good for an economy, the £100 million of gilts might be sold for £90 million. The face value is still £100 million and that’s how much the government has to pay back along with the £5 million annual interest. The new buyer is now getting £5 million interest on an investment of £90 million – a return of 5.55%.

If the government wants to borrow again, the investors will only play if the new bonds also carry a return of 5.55% or more.

This is the downward spiral that got Greece, Ireland and Portugal into trouble since it is considered that at 7% a bailout is required. Italy and Spain, the third and fourth largest countries in the Eurozone now have debt interest above 6% and heading towards 7%.

The problems of Italy and Spain are different.

Italy has a huge national debt – about 118% of GDP (what the economy produces in a year) but a relatively small annual deficit at a target of 3.9% for 2011 (see Wikipedia for latest statistics).

Spain on the other hand has big economic problems with very high unemployment at 21%, a high annual deficit but a lower national debt around 60% (see Wikpedia for the latest statistics).

In Italy, the size of the national debt is the concern (it is second behind Greece and not that far behind) while in Spain it is the annual deficit and how quickly the national debt is growing that is causing the problems.

Returning to personal finance and too much credit card debt, if you want to get back in control, first you have to stop borrowing more on the credit card and then you have to pay it back.

It’s the same with governments.

You have to close the annual deficit either by cutting public expenditure or raising more tax revenue. Only when the deficit turns into a surplus do you start reducing national debt.

The UK government is doing a bit of both. The Labour government introduced a new 50% tax rate for the high earners although previous experience indicates that this may have been more political than economic. When the Thatcher government reduced tax rates, the amount of tax collected by the government increased because there is more incentive to earn more.

The Conservative government increased VAT from 17.5% to 20% in January 2011. The impact on government spending is much less clear. For all the talk about cuts, UK government spending continues to go up (see UK public spending)

In the United States, the deal to get an increase in the national debt required agreement to reduce the annual deficit through spending cuts as the Tea Party congressmen stood firm.

Are Deficits Bad

Not in themselves, no.

John Maynard Keynes is the thinker behind the idea that during tough times for the economy, the government should be stimulating the economy by running an annual deficit.

Of course, his idea has been abused by the politicians. While Keynes favoured stimulating the economy when economic growth was low, he thought money should be clawed back through fiscal policy during the good times.

Former UK Chancellor and then Prime Minister, Gordon Brown made a big thing about his golden rules for fiscal responsibility:

annual deficits and surpluses should balance out over the economic cycle

national debt should be kept below 40% of GDP to keep it within sustainable levels.

While I may not agree with much that Gordon Brown did, these two rules were eminently sensible and were the backbone of government policy from 1997 to 1998. Unfortunately they were then abandoned to give the economy a boost, partly because of the credit crunch.

The Annual Deficit And It’s Role In Determining Aggregate Demand & GDP

Both the annual deficit and the national debt are often compared to GDP and you can start to see statistical tricks.

A government can run an annual deficit and still see it’s national debt go down as a percentage of GDP.

Eg GDP £1,000 billion

National debt £500 billion or 50%

Economic growth 3% p.a.

Annual deficit of £10 billion or 2% of GDP increases the national debt to £510 billion but economic growth has increased GDP to £1,030 billion.

Hey presto, the national debt as a %age of GDP has reduced to 49.5% (510/1030)

While there is an annual deficit and the national debt has increased in monetary value, it appears that the economy is doing well.

To complicate matters, the government’s fiscal policy plays a role in determining the level of GDP.

Strictly speaking aggregate demand is GDP with constant inventory levels. It is based on:

Consumption

Government expenditure less taxation

Investment minus savings

Exports minus imports

What we’ve seen in recent years is an economy that has depended on growth in consumer expenditure and government expenditure.

Both these have been financed by an increase in debt – personal debt has shot up in many countries and so has the sovereign national debt.

Savings rates are abysmal (savings are the opposite of personal debt) which is a concern with the demographic time-bomb ticking away with the ageing population and the pensions crisis.

The next few years are likely to see:

reduction in consumer expenditure – as people are much more reluctant to go into debt to fund their current lifestyles.

reduction in government net expenditure

increasing in the savings rate as debt is first repaid and then people start building up rainy day money

This is bad news for the economy and it’s easy to see how any of the countries struggling with debt can dip into a second recession and have a very long recovery period.

The lessons of what happens when national debt gets out of control are all around us with Greece, Portugal and Ireland already receiving bailouts and harsh austerity measures. Italy, Spain and Belgium look to be next on the list.

The United States is on the brink, it has a huge annual deficit at the moment and the UK is struggling to make the cutbacks stick. At the moment there is a lot of talk which gets the vested interests excited and screaming in the media but little effective action.

Worryingly, there is evidence that a high national debt acts as a big brake on economic growth.

Economists Carmen Reinhart and Kenneth Rogoff calculated that countries with public debt above 90 percent of GDP grow by an average of 1.3 percentage points per year slower than less indebted countries.

This is the trap that Italy has found itself caught in.

From 1981 until 2010, Italy’s average quarterly GDP Growth was 0.36 percent. That’s less than 1.5% per year.

This is the flaw in the aggressive Keynesian economic model of spend, spend, spend your way out of recession with the help of large annual deficits, regardless of the size of the national debt.

These are scary days.

All the money isn’t going to disappear from the economy but it does look like things are going to stay tight for the foreseeable future.

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